What is an Operating Agreement?

If you want to start a limited liability company, one of the most important steps in the process is drafting an operating agreement.

While this document is only legally required in a few states, an operating agreement is crucial for outlining the ownership structure and management style of any LLC. By drafting an operating agreement, you can avoid confusion and even legal issues down the road.

Two Different Types of Operating Agreements

There are two main types of operating agreements, depending on whether you operate a single-member LLCs or a multi-member LLCs. These two types of operating agreement vary in a few important ways.

Single-Member Operating Agreement

Even if you operate your own LLC, and serve as your own sole employee, it’s advisable to draft an operating agreement. Most states do not require you to file or even write down your operating agreement, but it’s still a good idea to do so.

A single-member operating agreement is so valuable in part because it can help legally separate your company from yourself. If a court decides that your LLC is not a separate entity, but rather an extension of you personally, your business can lose its limited-liability protection.

However, if you detail your company policies and business practices in an operating agreement, you can properly distinguish your LLC as its own entity. It is also important to designate in a single-member operating agreement what will happen to your company if you are no longer able to operate it for reasons such as illness or death.

Multi-Member Operating Agreement

If your LLC has more than one member, you’ll need to create an operating agreement that describes your management structure as either manager-managed or member-managed.

A multi-member operating agreement also needs to outline how members contribute money to the company, how they distribute profits, and how a member can be replaced.

Essential Elements of an Operating Agreement

There can be quite a bit of variation when it comes to preparing an operating agreement. There are, however, some key elements that most savvy business owners choose to include. With most operating agreements, you’ll see the following seven sections.

Organization

This important opening section describes where and when your limited liability company was founded. In addition, this is where you will lay out the ownership structure of your LLC. Are you the only owner, or are there several members?

Does everyone share equal membership, or do different members hold varying amounts of ownership in the LLC? These are a few of the most important questions you’ll need to answer in this section of the operating agreement.

Management

Another vital part of the operating agreement is designating a management structure. There are two different options for LLC management: member-managed or manager-managed. If you choose to have your members manage your LLC, which is the most common option, your members will oversee all operations of your company.

Alternatively, you may want to have a manager handle this job, allowing all other members to take a more hands-off approach to the day-to-day operations of the business. Either way, this decision should be clearly stated in your operating agreement.

Voting

Once you’ve determined your management structure, a multi-member LLC will need to designate how the LLC’s members will vote on company matters. The most common option is to give each member one vote.

However, if your members have varying levels of ownership, you may want to allocate their voting powers accordingly. Putting this information in writing will prevent potential confusion or conflict in the future.

Capital Contributions

Where did you acquire the money to start your company? How do you intend to raise more money in the future for your LLC, if necessary? These are important questions that you can answer in the capital contributions section of your operating agreement.

Distributions

Are your business profits and losses distributed evenly among your members, or are they divided a different way? When it comes to issues of profit distribution it’s vital that all members of your LLC are on the same page. Making these decisions together and putting them in writing can protect you and your business from costly infighting down the line.

Changes to Membership Structure

If there may be changes to your ownership structure at any point, it’s good to outline how those circumstances will be handled. In some states, your LLC can be dissolved by the state if a member leaves the company. Having a clearly outlined plan for handling these types of changes can save you time and potentially your business.

Dissolution

Sometimes, dissolution is a necessary step. While a small number of LLCs intentionally form for a limited period of time, for most, losing a company can be difficult to handle. For this reason, it’s important to have the process for dissolving your LLC clearly outlined in your operating agreement far in advance.

Optional Additional Elements

Depending on the exact structure of your LLC, there are some other items you may wish to include in your operating agreement. For example, while LLCs are not required to hold regular meetings, if your company wishes to do so, you should outline the process in your operating agreement.

Another item you may want to address is who has access to your company checkbook and credit cards. Will all the members have equal access? Will you restrict access to only your manager?

These are questions that many LLC owners choose to answer in their operating agreements to avoid dealing with this potentially contentious issues on a case by case basis.

Final Thoughts

Because operating agreements are only required in a few states (California, Delaware, Maine, Missouri, Nebraska, and New York), some LLC owners believe they are unnecessary. This could not be further from the truth. Whether your state expressly requires an operating agreement or not, it’s one of the most important steps in the LLC formation process.

There are countless ways that a properly written operating agreement can help you avoid problems down the road, and having one is absolutely in your best interest.

Additionally, it’s important to review your operating agreement whenever your LLC undergoes any major changes. As long as all of your members agree to a change, you can alter your operating agreement as your company grows and evolves.

Create Your Operating AgreementIf you’re ready to draft an operating agreement for your company, use this free tool. Simply sign up for a user account.

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